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What a shocker -- the Eurozone’s 'powers that be' are playing a high stakes game with some big questions lingering over the precedent they are trying to set. In some investor's eyes, the island of Cyprus could now 'unofficially' become the test case for the EUR's survival. This small controversial island's economy accounts for only +0.2% of the Eurozone’s gross domestic product (GDP), but its troubles are having a global impact on investors’ nerves this Monday morning.

On Saturday, the country received, in gesture, a European Union +€10b rescue package in return for a series of unusually harsh conditions. The deal included a one-off “tax” on depositors -- 6.75% for anyone with less than €100,000, +9.9% for anyone with more than that. No one was naive enough to believe that depositors were not going to bear the brunt of any conditions tied to the bailout. But no one anticipated small savers taking a direct hit 'somewhat forcefully' along with those with savings above the €100,000 insurance threshold.

It’s a given that all bailouts are unfair. The Eurozone’s policymakers are trying to show that they have learned a lesson or two while dealing with other debt laden Eurozone peripheries. In theory, following the proposed deal, Cypriot debt will come down to a manageable +100% of its GDP. As a country, would you not prefer this deal than the Greek situation of continued austerity and increasing debt that the populace is forced to endure? The European power brokers believe they have created the ideal cocktail for the country to survive within the Eurozone. Some fear that a line has been crossed, and naturally depositors across the European divide will be nervous. If Cypriot depositors are forced to pay today, will the same be asked (read: demanded) of the Spanish, Portuguese, or Italian depositors tomorrow?

Undermining Public Trust

The fears of deposit-led contagion to other parts of the Eurozone cannot be overstated; it’s a natural reaction and course of emotions. The Cypriot one-off tax has opened the risk aversion floodgates. Initial investor sentiment took a beating on the Australasia and European open – dragging the single currency, periphery bonds, and commodity prices much lower as investors fled from riskier assets. European policymakers, with one stroke of a pen, are in danger of undermining the public trust that supports the European financial system.

Does this now become a full blown crisis or merely a mini-crisis? That will depend on the Eurozone’s policymakers themselves. Are they able to sell this as a "one-off" and that Cyprus is a special case? Because of the initial investor reaction – and not the publics’ – will they change the terms of the deal? Indecision will not be regarded as strong leadership.

Most things are about perception and the Eurozone’s policymakers seem to initially have got it wrong in both investors’ and people's eyes. Under these terms there is a strong chance that the Cypriot government could vote "no" or it will further delay voting altogether. With Cyprus supposedly in talks to change the size of the levy on bank deposits, it has certainly eased some of the risk aversion pressure and allowed the EUR and its crosses to rally from their significant lows.

A New Eurozone Bargaining Template

It seems that the rational heads believe that the scope of potential contagion (deposit outflow, sovereign debt) is more limited that if such a decision had been taken in previous programs. Today, Europe in theory has a better safety net. The European Central Bank’s threat to intervene in the bond market is likely to have a calming effect; they are the market’s stop-loss or “get out jail card". That is not to say that risk-off trading will not continue to dominate foreign exchange, but can the EUR fully recover from here? This will most likely depend on what happens in Cyprus over the next little while.

The potential changing of the Cypriot terms has allowed the EUR to tentatively recover some of its initial -2% dive and regional bond and stock prices to steady. Nothing is yet carved in stone; authorities have time to amend the so-called deal. However, deposit protection schemes, or lack thereof, will dictate small investors’ reactions. Despite it being a one-off arrangement, it now provides a new bargaining template. Cypriot and Italian news headlines will surely dictate the EUR's price action this week. But come Wednesday, the Federal Open Market Committee decision may bring fresh incentive for the "mighty dollar." The U.S. Federal Reserve gets to update its economic projections and thanks to stronger fundamental data of late, coupled with the ongoing Eurozone saga, the dollar will look even better.

Rumors that a Cypriot vote will be delayed by a few hours to a few days will certainly keep the EUR bulls on high alert. Technically, the EUR and EUR crosses, especially JPY, will try and fill in the -2% gap first witnessed on the open Down Under. EUR outright sellers remain the dominant play, preferring to sell on rallies and looking for sub-1.28 in the coming sessions. Japan's Prime Minister Shinzo Abe is certainly not a happy camper this morning seeing his supposedly beleaguered currency rally. And the Swiss have not ruled out negative interest yields.

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